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MLPs Under Threat From The IRS

One of the biggest changes for investors over the next few years is going to come from the IRS. And it’s a potential bombshell that is flying below the radar for most investors. That bombshell is a result of proposed changes to the Master Limited Partnership structure that the IRS is considering.

Master Limited Partnerships (MLPs) have surged in popularity over the last decade as more and more investors have begun to realize their tax advantages. While MLPs do have some complex tax rules, they also have the potential to generate significant tax savings. This might explain why the number of MLPs has more than doubled since 2005.

But the 1987 U.S. law governing MLP status was too vague according the IRS, so last year the IRS announced it was rethinking its processes for deciding on which firms would receive MLP status. The IRS decision not only affects firms that will look for MLP status in the future, but also firms that have structured themselves as MLPs previously. This is a huge issue for many investors and the more than 100 different stocks that rely on the status. Related: Can This Next Shale Hotspot Live Up To The Hype?

The basic MLP investor is looking for tax-advantaged investment income rather than capital gains. If a stock were to lose its MLP status, many stockholders might abandon the shares and seek new investments that provided the tax-advantaged dividend income they need. The MLP is essentially a pass-through entity which enables it to be publicly traded yet avoid the double corporate taxation issue that bedevils most firms and slices a healthy chunk off their income.

In May of this year, the IRS came back and announced they had a new set of rules for MLPs. Unfortunately, like so many other IRS statutes, the rules may leave some investors wondering where their stock stands. The new rules are being interpreted to mean that many chemical manufacturing firms will lose their MLP status, while energy-related companies may get broader latitude. They also suggest that conventional pipeline operators, energy-logistics firms, and refinery partnerships will all qualify for MLP status. However, petrochemical producers will only qualify if their operations are part of a larger refining business. Related: This Is Why Oil Markets Shouldn’t Worry About Iran’s Comeback

Two energy stocks that are likely to be substantially affected by this rule are SunCoke Energy (SXC) and SunCoke Energy Partners LP (SXCP). SXC are engaged in producing metallurgical coke in the Americas and coal mining in West Virginia and Virginia. SXCP is part of the same vertical business structure and handles coke manufacturing as well as some logistics. Coke is used in blast furnaces for making steel, so the business has already been under pressure due to global macro conditions.

At the same time though, both SXC and SXCP have had a very tough time in the markets of late given the strong downward price drift over the last few months. It’s impossible to say how much of this is due to global macro conditions, but the new IRS regulations appear to be playing a significant role as well. Related: Mexico’s First Offshore Auction A Major Disappointment

SXC and SXCP issued a press release indicating “we believe that the proposed regulations as currently drafted support the position that the coking of coal is a qualifying activity.” Investors may be less sure. Both stocks have dropped significantly since the new regulations were proposed in May and commentators have suggested that MLP status may be at risk.

The new IRS regulations are only at the proposal stage and have yet to be finalized. For investors in these stocks, there are two keys points here: (1) do SXC and SXCP qualify under the new regulations, and (2) since the new rules are only tentative at this point, can SXC and SXCP convince the agency to modify the rules so that they qualify? If the answer to either of these questions is ‘yes’, then SXC and SXCP should see substantial upside from here – perhaps 30 percent or more. There is a risk of course, but much of the downside on the stocks already appears to be incorporated into the price. Sage investors should take note and do their own due diligence on the situation as it appears to present a major opportunity.

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